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What Exactly is a Recession, Anyway? — Lose the Legalese!

You can use a rule of thumb or be more precise. But don’t forget the bond markets.

The news these days is all about the possibility of a recession. A majority of economists thinks we are heading for a recession, but President Trump declares that the economy is strong. All the same, the president is looking for ways to stimulate the economy to avoid a recession.

Having said that, what exactly is a recession, anyway? We all know that a recession is a bad thing, but how do we determine whether we are in one?

Two Definitions of a Recession

There are two common definitions of a recession. They aren’t inconsistent with each other. It’s just that one is a rule of thumb while the other is more detailed.

The rule of thumb is that we are in a recession if there have been two consecutive quarters of decline in the Gross Domestic Product. The Commissioner of the Bureau of Labor Statistics suggested this measure as one rule of thumb in a New York Times op-ed forty-five years ago. It’s pretty well stuck over time.

The National Bureau of Economic Research has a more detailed definition of a recession. It says a recession is

a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP [“Gross Domestic Product”], real income, employment, industrial production, and wholesale-retail sales.

Economists, academics and the government prefer this definition because takes into account a lot more than just the Gross Domestic Product. Plus it necessarily isn’t sliced into quarters.

What’s the Gross Domestic Product?

Investopedia provides the standard definition of the Gross Domestic Product (GNP) and tells us why it is important:

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of the country’s economic health.

In other words, the GDP for the United States is the value of everything we make or do in a given year. If the GDP goes up, we prosper. If it goes down, we can be in economic trouble.

What’s the GDP Been Lately?

The Bureau of Economic Analysis calculates the United States’ GDP. It makes an initial estimate, then as the months go by and more data comes in, the Bureau of Economic Analysis tinkers with the number. The initial estimate for 2018 was $20.50 trillion.

Remember the rule of thumb for recessions? Two consecutive quarters of decline in the GDP? The Bureau of Economic Analysis also keeps track of the GDP quarterly. The Bureau of Economic Analysis reports not only the raw numbers, but the percentage of increase or decrease over the past quarter. Here are some some figures showing quarterly GDP percentage changes over the past few years:

According to the rule of thumb, we aren’t in a recession now because there has been only one quarter in 2019 where the GDP fell. And if two quarters means a recession, why didn’t everyone say we were in one during the second half of 2018, when the GDP fell twice, in consecutive quarters? Maybe it’s time to forget the rule of thumb and use the detailed definition of a recession to look at the broader economy.

The Inverted Yield Curve

If the rule of thumb doesn’t work, yet the economy is slowing down, how can we say that we are headed for a recession? There is a predictor of a coming recession called the “inverted yield curve.” This predictor has proved accurate most of the time to predict recessions. And it’s inverted right now, so economists are worried.

The inverted yield curve has an intimidating name, but all it means is that the interest rate on long-term debt — in this case US government bonds that don’t mature for ten years — is less than the interest rate on shorter-term bonds, those that mature in two years. The thought is that when the interest rate is “inverted,” it means that investors don’t have much faith in the economy in the short term, only in the long term. In other words, investors are hunkering down because they fear a recession. This inversion, coupled with the kinds of data the detailed definition of a recession includes, are what has economists spooked.

Recession is Headed this Way, But Not Here Yet

Why all the hooray over a recession if the GDP is still positive? Nothing, on that front. But the economy is slowing down and the inverted yield curve predicts trouble ahead. The massive income tax cuts that took effect in 2018 didn’t help any because our national debt has mushroomed. History tells us that the president’s tariffs aren’t helping, either. The Smoot-Hawley Tariff Act of 1930, which the government thought would help protect American farmers and other US industries from foreign competition, exacerbated the Great Depression. One would hope to learn from history.

Originally published at https://losethelegalese.com.

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Jimmy Verner

Long-time, semi-retired lawyer who practices business law and corporate law online and likes to write about it.